Liquidity concerns for US and European corporate bond markets are not new. But the rise of “flash events” since the crisis in the absence of clear fundamental drivers, including in some of the world’s most historically liquid markets, has rightly captured the attention of market participants and policymakers alike. Both the level and the resilience of liquidity are important for market participants. Unfortunately, no single metric fully captures both concepts, making it impossible to easily summarise liquidity conditions across markets. The overall level of liquidity does not appear low. Markets seem to be working reasonably well, especially in periods of low stress, with many liquidity measures not materially worse than pre-crisis. The fact that the period just before the crisis in many cases saw extraordinarily benign liquidity conditions may be contributing to the sense of low liquidity.
But this is not to say there is no issue. There is evidence of deterioration in some liquidity metrics in recent years even during periods of relatively low volatility. And more concerning, liquidity has proven to not be resilient, as seemingly ample liquidity has been an illusion during times of stress, exacerbating market moves and contributing to volatility. What has driven the changes in liquidity conditions? In fixed income markets observers have focused on the large drop in dealer bond inventories at a time when the bond market was expanding, blaming tighter bank regulation post-crisis. But this is only part of the story: both cyclical and structural factors are playing a role. Markets are finding ways to adapt to these evolving liquidity conditions. Alternative liquidity providers, such as hedge funds, private equity firms, and primary trading firms in electronic markets, have emerged as banks scale back their market making and liquidity provision. The final impact on liquidity is still uncertain. On the investor side, one response has been to look at ETFs and mutual funds to manage liquidity risk, but this comes with its own set of issues – think of the liquidity mismatch between an illiquid high yield bond and the high yield ETF offering daily liquidity. Ultimately, the factors affecting liquidity are unlikely to recede anytime soon, suggesting that liquidity is likely to remain fragile. Investors should brace themselves for continued “flash events” and bouts of volatility.
Source: Deutsche Bank Research